Once you’ve determined your risk appetite, it’s time to think seriously about diversification – our third strategy of successful Prosper Lenders.
STRATEGY THREE: Diversify, diversify, diversify!
Our most successful lenders are well-diversified. Within Prosper’s social lending marketplace, there are two primary ways to diversify.
The first and most important way to diversify is to secure a large number of Notes. Generally speaking, holding more Notes reduces the volatility of returns a lender will experience.
Let’s start with a simple example. Say you had $5,000 to invest in personal loans: would you lend all $5,000 to one person? Or, would you be more comfortable lending smaller dollar amounts to more people – say $50 across 100 borrowers?
If you lent all your $5,000 to one borrower, who then paid everything back with interest, then congratulations! You got all your expected return. But if that person hit hard times and paid you only partially or not at all, then you’ve lost your principal and your gains.
But if you lent $50 across 100 people, you’ve spread your risk across all these people – not concentrated on just one borrower – and your volatility of expected returns will be less.
It’s difficult to predict the default risk of a solitary personal loan, despite our strict credit policy and borrower qualification screening. But when you spread the risk across tens – if not hundreds – of loans, your default risk is more predictable. This idea, albeit somewhat simplified here, is a cornerstone of modern investment theory, and we have historical data of our own to back it up.
So if you expect your total investment to be less than $2,500, consider investing just $25 per loan. For larger investment amounts, your bid size determines how much diversification you will get for your total investment. For example, if you had $10,000 to invest, consider increasing your bid size accordingly – such as to $50 or $100 per Note – to remain diversified while not diluting your chances for an attractive return.
Now that you know to invest in a large number of Notes, it’s important to start thinking about how to diversify within those Notes. Because at its heart diversification is not just about the number of Notes that you have – it’s also about the covariance, which is a fancy term for inter-relationship, that those Notes exhibit.
Covariance can be a tricky concept, but at its simplest it just measures how two things move together. For example, when the price of gold goes up, the stock price of gold mining stocks often goes up as well. To understand how that relates to Prosper and why it’s important, let’s think about two people: John Doe and Susie Smith, and each has taken out a loan.
1. For our first scenario, assume that John and Susie live in different states, work in different industries and for different companies.
2. For our second scenario, imagine that, not only do they live in the same state and city, but they also work for the same department of the same company.
We would expect the covariance in those scenarios to be very different. Imagine what would happen if John had worked for the auto industry during the recent economic downturn. In Scenario 1, such an event would likely have little or no impact on Susie’s ability to repay her loan, which is clearly not the case for Scenario 2, in which they could both be subject to the same unfortunate circumstance of potential job loss. Diversification works best when we reduce those kinds of inter-relationships.
For this reason, lenders should consider diversifying by investing in different types of Prosper Notes. And don’t just limit yourself to a wide range of Prosper Ratings! You can also consider:
- The term of the loan (one-year, three-year, and five-year)
- The purpose of the loan (debt consolidation, home improvement, etc.)
- The state where the borrower lives
- The borrower’s occupation
By investing in a large number of Notes differentiated across the above factors, you can mitigate your portfolio’s exposure to individual risk and certain forms of economic risk.
If you’re not already an active Prosper lender, take these principles to heart as you begin to build your portfolio.
If you’re already a Prosper lender, review your Notes to evaluate your current diversification strategy. Consider whether your distribution of Prosper Ratings is compatible with your appetite for risk. Have you adequately spread your investment amount across multiple loans? For future investments, consider how you can better diversify. And feel free to share your thoughts and strategies with us in the comments below!
Stay tuned next week, when we’ll talk about how to further manage risk by taking advantage of Prosper’s investment tools.